Tuesday, September 14, 2010

Are we irrational investors by design?

Are we rational beings devoid of emotions when we make our investment decisions? Modern investment theories like CAPM (Capital Asset Pricing Model) or EMH (Efficient-market hypothesis) make this assumption that we humans are rational beings who try to maximize our selfish interest. Human emotions are seen as external factors that do not play any role in investment decision making. This assumption gives rise to the idea of a species called homo economicus or "the economic man" which is found only in economic books. To me, homo economics sounds more like a Vulcan (i.e. the alien race of the Star Trek character Spock) than human.

We, humans, are emotional, complex and often irrational beings who are affected by the emotions and actions of others around us. These human traits have served us well in our evolutionary journey to reach the top of the
evolutionary pyramid. Financial investment is relatively new activities in our evolutionary journey and the skills that evolved over millions of years of evolution may not work as well here. For example, we are more adept in thinking in relative terms than in absolute terms. Thinking in relative terms, like am I stronger than the other person or am I more attractive than the competition, worked well than thinking of an absolute number that represents your strength or beauty. When it comes to investment, we need to think in absolute terms than in relative terms. This is more significant in cases where the outcome of the decision is risky. Following the experiment makes this more evident.

Assume that you are in a situation where you are given Rs 1000 to keep and then presented with two options. If you choose option one you would be given Rs 500 more to take home and option two is that a coin is flipped and if it is heads you gain Rs 1000 more and if it is tails you lose nothing. Which option would you choose?

Now let us consider another situation, where you are given Rs 2000 to keep and then presented with two options. If you choose option one Rs 500 will be taken away from you and option two is that a coin is flipped and if it heads you lose nothing and if it is tails you lose Rs 1000. Which option would you choose?

What is seen is that the majority of people choose option one if the first experiment and option two(which is riskier) in the second experiment. In absolute terms, both the experiments lead to the same outcome a 50/50 bet for Rs 1500 but we had two entirely different choices. This human behavior is known as loss aversion and it tends to make us take a riskier choice in the decision where losses are involved.

The most interesting thing is that in an experiment Capuchin monkeys have shown the same loss aversion behavior as a human being. This points to the fact the irrational financial decisions are results deep-rooted genetic deficiencies in human beings. It is more like the incapability to fly like a bird or swim like fish. This has not prevented us from conquering the skies or swimming in deep oceans. We invented tools to overcome our deficiencies, just like that we will have to develop financial tools that will help us overcome our genetic deficiencies and make better financial decisions.